Bond risk premiums -- certainty found and lost again

This is a second post from a set of comments I gave at the NBER Asset Pricing conference in early November at Stanford.  Conference agenda here. My full slides here. First post here, on new-Keynesian models

I  commented on "Downward Nominal Rigidities and Bond Premia" by François Gourio  and Phuong Ngo. The paper was about bond premiums. Commenting made me realize that I thought I understood the issue, and now I realize I don't at all. Understanding term premiums still seems a fruitful area of research after all these years.  

I thought I understood risk premiums

The term premium question is, do you earn more money on average holding long term bonds or short-term bonds? Related, is the yield curve on average upward or downward sloping? Should an investor hold long or short term bonds? 

Prices vs. inflation and a mortgage puzzle

Mickey Levy's excellent WSJ oped leaves some thoughts. 

Inflation has fallen, though I still suspect it may get stuck around 3-4%. But prices "are 18.9% higher than its [their] pre-pandemic level." And some important prices have risen even more. "Rental costs continue to rise in lagged response to the 46.1% surge in home prices."  Those who are taking a victory lap about the end of inflation (the rate of change of prices) are befuddled by continuing consumer (and voter) anger. 

Well, prices are not the same thing as inflation.

Evergreen expectations

 

A lovely plot from the always interesting Torsten Slok. The graph shows the actual federal funds rate, together with the path of "expected" funds rate implicit in fed funds futures market prices. (Roughly speaking the futures contract is a bet on where the Fed funds rate will be at various dates in the future. If you want to bloviate about what the Fed will do, it's easy to put your money where your mouth is!) 

A lot of graphs look like this, including the Fed's "dot plot" projections of where interest rates will go, inflation forecasts, and longer term interest rate forecasts based on the yield curve (yields on 10 year bonds imply a forecast of one year bonds over the 10 year period.) Just change the labels. 

How many banks are in danger?

With amazing speed and impeccable timing, Erica Jiang, Gregor Matvos, Tomasz Piskorski, and Amit Seru analyze how exposed the rest of the banking system is to an interest rate rise.

Recap: SVB failed, basically, because it funded a portfolio of long-term bonds and loans with run-prone uninsured deposits. Interest rates rose, the market value of the assets fell below the value of the deposits. When people wanted their money back, the bank would have to sell at low prices, and there would not be enough for everyone. Depositors ran to be the first to get their money out. In my previous post, I expressed astonishment that the immense bank regulatory apparatus did not notice this huge and elementary risk. It takes putting 2+2 together: lots of uninsured deposits, big interest rate risk exposure. But 2+2=4 is not advanced math. 

How widespread is this issue? And how widespread is the regulatory failure? One would think, as you put on the parachute before jumping out of a plane,  that the Fed would have checked that raising interest rates to combat inflation would not tank lots of banks. 

Banks are allowed to report the "hold to maturity" "book value" or face value of long term assets. If a bank bought a bond for $100 (book value) or if a bond promises $100 in 10 years (hold to maturity value), basically, the bank may say it's worth $100, even though the bank might only be able to sell the bond for $75 if they need to stop a run. So one way to put the issue is, how much lower are mark to market values than book values? 

The paper (abstract):  

The U.S. banking system’s market value of assets is $2 trillion lower than suggested by their book value of assets accounting for loan portfolios held to maturity. Marked-to-market bank assets have declined by an average of 10% across all the banks, with the bottom 5th percentile experiencing a decline of 20%. 

... 10 percent of banks have larger unrecognized losses than those at SVB. Nor was SVB the worst capitalized bank, with 10 percent of banks have lower capitalization than SVB. On the other hand, SVB had a disproportional share of uninsured funding: only 1 percent of banks had higher uninsured leverage. 

... Even if only half of uninsured depositors decide to withdraw, almost 190 banks are at a potential risk of impairment to insured depositors, with potentially $300 billion of insured deposits at risk. ... these calculations suggests that recent declines in bank asset values very significantly increased the fragility of the US banking system to uninsured depositor runs.

The Fed and the Debt Limit

What's the matter with a temporary delay in paying interest and principal on debt, if the debt limit hits? Collateral. Financial institutions can easily borrow using treasury securities as collateral.  If a treasury is in technical default, it suddenly can't be used as collateral, or you can borrow much less money with it. Thus even a technical and temporary default, even if we all know Uncle Sam will eventually repay the debt, is dangerous to the financial system. (Why we have so much short term collateralized borrowing is a topic for another day. We do, and unwinding it suddenly would be bad.) 

Earlier I argued that the Treasury should stand up and say "we will pay interest and principal on Treasury debt before we pay anything else." It's important to say that now to avoid a run. I suspect they will do it in the end, but want to use the threat of a crisis to get Congress to raise the limit promptly. If so, they're playing with fire, as runs start ahead of time. 

Today, however, I've been thinking about what the Fed can do. First, the Fed can say right now, in the event of a debt ceiling technical default, we will suspend all our rules and allow financial institutions to lend against treasury collateral with customary (tiny) haircuts, ignoring the technical default. Second, the Fed can say it will lend freely against treasury collateral to banks, or via reverse repos to financial institutions, with no haircut, even if the securities are in default. Third, the Fed can say it will buy Treasurys. It will fix a low rate of interest and buy all anyone wants to sell at that price. Will private markets make some money off this? Yes. Fine. That's the point. Hang on to your treasurys, you'll make some money is a lot better than starting a crisis. If the Fed overpays, it just remits less to Treasury eventually. 

Say it now, so there is no run as the debt ceiling approaches. 

The one thing Fed and Treasury will clearly not be able to do under a debt limit is to run another big bailout. So make darn sure we don't need one! 

What about the trillion dollar coin? Clever, but as before, issuing interest-only debt is even more clever. The debt limit only counts principal, not market value, so interest only debt doesn't count! But both that and the trillion dollar coin are so obviously against the spirit of the debt limit, that if Treasury is worried about its authority to prioritize treasury debt over (say) electric car subsidies, then either is not worth discussing. 

Updates:

Chris Russo wrote in Barrons Sept 2021 reporting on internal Fed strategizing for this event. 

The Fed will treat defaulted Treasury obligations the same as non defaulted obligations. Their regulatory treatment will remain the same including capital requirements and risk weights. Moreover these securities "will not be adversely classified or criticized by examiners." 

Policy makers would "presumably want to avoid the impression that the Federal Reserve was effectively financing government spending." 

The Fed will 

transact with defaulted securities at market prices

Eventually 

The Fed could move the defaulted securities on to its balance sheet [English translation: buy] ...this set of options is the most contentious. Powell described them as "loathsome"... the institutional risk would be huge. The economics of it are right but you'd be stepping in to his difficult political world and looking like you are making the problem go away. Lacker called it "beyond the pale." John Williams... supported keeping those options on the table. ...no Fed governor categorically rejected the third option. 

As I read it, this is considerably less than what I described. The Fed worries here about not inadvertently forcing individual banks to treat treasury assets as defaulted securities, which is good. But the main issue is whether financial markets, many not banks, will accept treasury collateral for lending, or whether we have as in 2008 a grand unwinding of the chain of short-term financing due to lack of collateral. Only the "loathsome" option addresses that issue as far as I can see. And if you want to stem a collateral run, it's best to clarify ahead of time. 

Casey Mulligan inquired

I am confused about your proposal.  Fed is part of the government. With currency in circulation not (?) counting against the debt limit aren't you suggesting the Treasury debt be (contingently) replaced with currency? Or would the Fed be defaulting on whatever asset it lends out?

Boy, if I didn't explain it well enough for Casey, I must really need a remedial writing course. Answer/clarification: 

Sorry if not clear. Fed can buy / lend against existing treasury debt, in default, and offer cash/reserves in exchange. This solves the financial crisis issue. It does not allow the treasury to borrow more, or the Fed to finance deficits. 

Two points on the debt limit, 1 serious 1 fun

Everyone keeps repeating that hitting the debt limit would necessitate a default on principal and interest. The Treasury itself says 

Failing to increase the debt limit would have catastrophic economic consequences. It would cause the government to default on its legal obligations – an unprecedented event in American history. That would precipitate another financial crisis and threaten the jobs and savings of everyday Americans – putting the United States right back in a deep economic hole, just as the country is recovering from the recent recession.   

The first statement is correct. The second is not. The government is still hauling in tax revenues. The Treasury could easily say "given the catastrophe that a default would produce, we will always pay interest and principal on treasury debt before any other payment." Congress could pass a law stating that fact. There is no economic reason  that a debt limit should force a default. 

There is a legal argument, and a claim that the Treasury cannot prioritize debt payments over other legally mandated payments. In the research I've been able to do however, this is a very uncertain claim. And it makes no sense. The Treasury is legally obligated to make debt payments, as it is obligated to pay Social Security checks, and also legally obligated not to borrow. Law prescribes the impossible. It has to prioritize. Indeed, unpaid bills are a form of debt, so if you want  to be a stickler, the government will violate the debt limit no matter what it does. 

The second statement is false. The US has defaulted on  gold clauses in the 1930s. It has defaulted on other "legal obligations."

The third is correct, and appropriate. If we are to tussle over paying Wall Street fat cats vs. grandma's social security, keep in mind just what a catastrophe default would be. Grandma will be way worse off if that happens. Treasury debt is now the golden collateral, supporting most of the financial system. (We should have a financial system much less dependent on short term collateralized borrowing, but that's another story.) If in default it would not be. Worse, and most important here, if financial markets suspect a default will really happen, they will start refusing to accept treasury collateral in the first place. This is basically what happened in 2008 with mortgage backed securities. They didn't fall to pieces,  they just weren't acceptable as collateral any more. 

A flight from treasury collateral under a debt limit would be far worse. And the government's magic tonic, borrow a ton and bail everyone out, would be unavailable. 

Perhaps Treasury thinks that by threatening default, they can get Congress to wake up and raise the debt limit promptly. But this risks Wall Street also believing the threat and causing the panic you're trying to prevent. 

Treasury secretary Janet Yellen should say out loud, right now "we pay principal and interest on treasury debt first, before anything else." President Biden should back her up. Drastic delays in social security, medicine, government shutdown and more are plenty enough threat to get Congress to move, without risking a run. 

States with balanced budget rules are interesting legal precedent. The State of Illinois, while I was watching, simply delayed payments, often by years. It paid its bonds on time. That isn't a good outcome of course, but it represents the State's choice of how to handle the legal requirement to pay vendors and to pay interest and principal on bonds. Other states have defaulted as have cities and counties. And countries. 

*****

Now for fun. Just print money, some say. Fortunately, our legal system is full of mechanisms to prevent the government from printing money instead of borrowing it. The treasury has to issue debt; the Fed has to buy it,  and thereby give the Treasury new money to spend.  That violates the debt limit. But Treasury can create coins. So, last time, the fun suggestion of $1 trillion dollar coins came up. 

Here is a novel proposal in the same sprit. The debt limit is calculated based on face value, not market value of debt. A bond promising $100 in 10 years and $3 coupons from now to then counts as $100 of debt. So issue perpetuities. Or, more realistically, issue coupon only debt.  The government could issue a bond that pays a $3 coupon for 30 years and no principal payment. As things are now calculated, that bond adds zero to the debt! 

Like the trillion dollar coin, this proposal so clearly violates the spirit of the debt limit that I doubt serious people would do it. It does point to a serious shortcoming in how the Treasury calculates debt however. Most of the time Treasury issues debt at par, borrowing $100 and promising to repay $100 in 10 years. Then the distinction does not matter. But the formulas should be fixed. 

Disclaimer: I'm not an expert on the law of the debt limit. If these points are in error, let me know and I'll issue a "never mind." 

****

To clarify, this is just a fun way to get around the debt limit if one wants a fun way to do it. It's not obvious that getting around the debt limit is a good idea. What is the justification for running primary deficits right now? No, I'm not a balanced budget nut. In times of crisis, war, pandemic, and recession, the government should borrow, for standard tax-smoothing reasons. But then the government should repay the debt. When the economy is humming and there is no crisis on, we should be running small steady primary surpluses. That is now. One has to argue that yes, we should get there, and stop borrowing in good times,  but it's too hard to do all of a sudden. But just what are those adjustment costs? A crisis is a terrible thing to waste. Today is as good a day as any to clean up the US long term fiscal mess. It's not clear to me that Washington does anything better if it takes a long time to do it. 

 

More UK finance regulatory failure

In previous blog posts here and here, I criticized UK financial regulators for missing simple leverage and margin requirements in UK pension funds. To be clear, I don't criticize the people. The point is, if after 10 years of intense regulation, a group of really smart and dedicated people can't see plain old leverage, the whole project of regulating risks is broken. And it's not just the UK. The Fed bailed out money market funds in 2020. Again. 

I insinuated the regulators were not paying attention. I was wrong. It turns out they were paying attention. Which makes the failure all the more stark.  

In Friday's Wall Street Journal, Greg Ip writes 

In 2018, the Bank of England investigated whether a big rise in interest rates would trigger a cascade of forced selling by bond investors, destabilizing the financial system. The answer was no, 

That they did think about it, and they missed it anyway is even more damning for the regulate-risks project. 

Nobels and financial crises

 (At National Review)

What This Year’s Nobel Economists Can Teach Us about Financial Crises

This week, economists are celebrating the Nobel Prize given to Ben Bernanke, Doug Diamond and Phil Dybvig for their work on banking.

Bernanke pointed out that banks matter. In the Great Depression, banks failed, and there was nobody left who knew how to make new loans. The economy contracted, not just for lack of money or for animal spirits of investors, but for lack of credit. Diamond and Dybvig wrote the classic economic model of bank runs, which shows how banks can fail even when they are “illiquid” rather than “insolvent.” The logic works like this: The bank has invested our money in illiquid projects, so if I suspect others are going to run to get their money out, I run to get mine out first before it’s all gone. 

But it is no insult to say that these are not eternal verities. The papers were written about 40 years ago. Each was the launching pad for a vast and important investigation. Indeed, Nobel Prizes largely recognize that sort of lasting influence on subsequent work. But that subsequent investigation opens new possibilities. Newton is no less profound for having been followed by Einstein. Each also sought to understand the world as it was, which is how one should start. But there are other possibilities for how the world might be — and how it might be better. 

UK finance fable update

Update to my previous post on the UK treasury imbroglio: 

The Bank of England explains, saying about as much as I did. Pension funds levered up, lost money when treasury prices fell, needed to post collateral, and then started selling en masse. The explanation starts with lovely central-bankerese (my italics): 

Against the backdrop of an unprecedented [really? Literally never?] repricing [translation: fall in prices] in UK assets, the Bank announced a temporary and targeted intervention on Wednesday 28 September to restore market functioning in long-dated government bonds and reduce risks from contagion to credit conditions for UK households and businesses. 

It goes on to a hilarious graph to explain how you lose money when you borrow to lever up a portfolio:

Why is this so funny? Notice on the left hand side a gap between assets and liabilities, yet in the fourth bar there is a positive "capital" bar.  Accounting 101, assets = liabilities, including capital. I guess UK regulations operate differently. 

But enough fun, let's get to the point. In answer to my question, roughly "you're supposed to be this great gargantuan regulator, how could you miss something so simple?," the bank offers, deep in the report, this: 

The FPC has previously identified underlying vulnerabilities in the system of market- based finance, a number of which were exposed in the ‘dash for cash’ episode in March 20202. The Bank and the FPC strongly support and engage with the important programme of domestic and international work to understand and, where necessary, address those vulnerabilities.

The FPC conducted an assessment of the risks from leverage in the non-bank financial system in 2018, and highlighted the need to monitor risks associated with the use of leverage by LDI funds. 

It's so nice you've been studying this. But then double, how did this happen? 

Out of the box risks

Policy Tensor on the consequences of a Russian nuke (HT Marginal Revolution) was very interesting: 

Consider the least escalatory option, that of a “demonstration detonation”: Russian forces air-burst (to avoid the nuclear fallout that results from a ground detonation) a tactical nuclear weapon with sub-kiloton yield (ie, no bigger than a big conventional weapon) over uninhabited territory somewhere in south-eastern Ukraine. This would be consistent with Russia’s “escalate-to-deescalate” doctrine ... What happens then?

Precisely because it is such a dramatic break with precedent, even a demonstration detonation would radically change the character of the Russo-Western conflict over Ukraine. New Yorkers and Berliners etc, are likely to flee the cities. Everywhere, in Europe and America, supermarkets would likely empty within hours. Many local authorities may institute civil defense measures, even as federal governments everywhere urge calm. A widespread breakdown of law and order would be a real possibility; especially in America, where it would be attended by partisan passions and finger-pointing....

Not to bash a hobby horse, but the Fed, SEC, FDIC and so forth are now obsessed with climate risk to the financial system. Chatting with colleagues at the Fed, it is astonishing how much and how detailed the research is in to climate (really weather) scenarios, much of this directed by higher-ups. 

Today I will not criticize that effort. Maybe pianos do fall from the sky.  What is striking to me, verified in every conversation I have with people in these institutions (please prove me wrong!) is that nobody at these institutions is doing any analysis of any other risk. 

This seems like a useful one, for example. Any nuclear explosion is going to make the ATMs go dark. Is anyone at the Fed gaming this out? What if (when) China blockades Taiwan? What about a massive cyberattack on the banking system, a deliberate attempt to cause a run (Russian disinformation that a major bank has had all its account information wiped out, get your cash now)? A new pandemic that looks more like 1350 than the flu?  

A familiar finance fable in UK bonds

Guy Adams in the Daily Mail has an intriguing story of what's going on in UK bond markets.  It's intriguing because it's so utterly familiar. And it reveals that all the masses of regulation and armies of regulators aimed at preventing exactly this sort of thing from happening again and again have failed again. 

UC pensions take in contributions when people are young, invest them, and then pay out fixed amounts when people get old. They hold large quantities of government bonds, currently 1.5 trillion pounds per Adams. That's a good strategy: if you have fixed payments to make, invest in risk free assets that provide fixed payments, and ignore the mark to market. But it fell apart in a classic way. 

Leverage

As often is the case, however, they didn't have enough assets to pay out the promises. So... Lever up! Pensions used their government bonds as collateral, borrowed money, and invested that money in more government bonds or, to a lesser extent, in stocks or other investments. 

ECB word salad hubris

The  Speech by the ECB's Isabel Schnabel, advertised on the official ECB twitter stream 

caused a characteristically grumpy outburst from me. Savor the ECB's tweet in all of its glory: 

We will not tolerate changes in financing conditions that go beyond fundamental factors and that threaten monetary policy transmission.

Also, 

In December of last year, we made clear that we would not tolerate price adjustments that would undermine the transmission of our monetary policy

So now central bankers know what "fundamentals" are in all asset prices, and "will not tolerate" bond prices (aka "changes in financing conditions") that deviate from their idea of "fundamentals." And I thought they had an inflation mandate, and a short-term interest rate "tool." 

The contrast between the vision of detailed machinery that central bankers think they know how to control and any actual scientific knowledge of the monetary and financial system is gaping. The one thing I actually know as an "expert" is how little anyone else actually knows. Nobody really knows what the "monetary transmission mechanism" is to start with, let alone how "financing" conditions affect it. And if Ms. Schnabel knows reliably how to distinguish prices from "fundamentals" I know a lot of hedge funds that would pay her a whole lot more than the ECB does! 

As one way to see that gap, I compiled the following list of central-bankerese from her speech. At a minimum, if you want to be a central banker, learn to talk like this. As a human, ask yourself if anybody actually knows what any of this word salad actually means, let alone if the ECB has the technical knowledge to control it. (Some, of course, is just complex euphemism.) If I knew more computers it would be great fun to program up an AI that can replicate a central banker. It shouldn't be that hard, because nobody knows what any of this means! 

Your central banker word-salad vocabulary list: 

  

vulnerability to fragmentation risks 

disruptive and self-fulfilling price spirals 

financing conditions 

wedge 

national borrowing conditions

fragmentation 

Irwin on trade reform

Doug Irwin of Dartmouth gave a really informative talk at the Hoover Economic Policy Working Group, based on his paper The Trade Reform Wave 1985-1995, AER May 2022.  Embed (hopefully) below, or go to the link here.  

 

Doug opened my eyes, hence this post. I love learning something new. I'm a resolute Free Trader. So, naturally, I jump to the answer: Stop protecting industries. Get rid of tariffs. Don't bother with the negotiated mercantilism of trade deals -- the "you can sell to us if our exporters can sell to you" deals. The point of a foreign country's exports is to get dollars, and the point of dollars is for them to buy from the US. Full stop. 

Doug reveals that this story is far too simplistic to understand the closed economies of the 1950s through 1970s, and the great trade liberalization that the world experienced starting in the 1980s -- and which we are very sadly likely to lose in the years ahead. A little reminder of what we gained, and a sad peak: 

The process of liberalization started with money, not tariffs: Countries first devalued overvalued currency, usually to a floating rate. Then they eliminated quantitative restrictions on imports including import licenses. Then they reduced tariffs. 

In turn, how did they get there, and why did they not reform earlier? The standard story pits domestic industry vs. consumers. Domestic industries have concentrated interest in protection, consumers are diffuse. That accounts for status quo bias, but not why they eventually changed. 

The source of the problem, and reason for the change is different. Countries (especially in the "developing" world) were hit with a "terms of trade" shock -- they exported commodities, say, to import goods; the commodity price went down so they could not buy imports. Many countries were financing imports with foreign aid and borrowing, and those transfers dried up. 

What do they do? They have to choose between deflation, currency depreciation, or import controls.  Deflation at the same exchange rate makes foreign goods more expensive. Depreciation does the same, without changing the domestic price level. Or, stop imports by direct controls, and by rationing foreign exchange leading to a black market. In the early postwar view, consistent with Bretton Woods, they chose the latter. (Why is there so much nostalgia for Bretton Woods? It was a rotten system.) 

Naturally, it didn't work. Eventually they gave up and devalued or floated the exchange rate. Now there is no need to ration foreign exchange or to restrict imports by license. (Tariffs are bad, but quantitative restrictions are worse, since you never know what the cost is, and then imports are allocated by political rather than economic reasons. Just paying a tax is more efficient!) They moved to exports in order to generate foreign exchange to buy imports. 

So, Doug answers the central question: 

Why no reform in 1970s? “foreign exchange reserves kill the will to reform” 

Oil and commodity export countries were flush with cash to buy imports. Foreign aid recipients had cash to buy imports. 

Why reform in 1980s?

Era of scarce foreign exchange – all three BOP shocks.

Goal: increase foreign exchange earnings by increasing exports.

Learning from experience – cost of import controls, benefit of exports

Shift from import repression to export promotion to overcome foreign exchange shortage 

And, later, 

Michael Bruno (World Bank): “We did more for Kenya by cutting off aid for one year than by giving them aid for the previous three decades”

Aid lets a country put off reform. 

I asked one question, about the importance of an open capital account. That also used to be gospel, now under debate. Doug's answer was interesting: In these cases, a free currency market was crucial, but free capital markets less so. 

Ideas matter.

This process did not just play out in standard political economy terms, one interest group gains power over another. The shift of ideas in universities, the IMF, central banks, and countries was crucial. I find this heartwarming as a producer of ideas, and terrifying as I watch these successful ideas crumble around me. 

Doug discusses the process of reform in Mexico, (which first had disaster under some bad ideas, then reform when a new group of economists came in), India, South Korea and others. Listen to the talk! 

Concluding slide: 

Important questions unasked of the Fed

This weekend's WSJ essay "How the Fed Averted Economic Disaster"  by Nick Timiraos finally brings into public discussion the second question we should all be asking of the Fed. What happened in the grandest bailout of all time in the covid crisis, and, more importantly, having done it twice, how are we going to avoid massive bailouts becoming the normal state of affairs? (The first question, of course, is "how did you miss inflation so drastically and when are you going to do something about it?") 

They were offering nearly unlimited cheap debt to keep the wheels of finance turning, and when that didn’t help, the Fed began purchasing massive quantities of government debt outright.

Translation: When dealer banks weren't buying treasury debt fast enough, the Fed lend the banks money to buy the debt, and quickly bought up the massive amount of debt themselves. 

The Fed followed by bailing out money market funds, buying state and local government debt, buying exchange-traded funds that held junk corporate debt, and announcing a do whatever it takes pledge to keep corporate bond prices high. It worked

It worked. The Fed’s pledges to backstop an array of lending, announced on Monday, March 23, would unleash a torrent of private borrowing based on the mere promise of central bank action—together with a massive assist by Congress, which authorized hundreds of billions of dollars that would cover any losses.

...Carnival Corp. , the world’s largest cruise-line operator. Its business had collapsed as Covid halted cruises world-wide. Within days of the Fed’s announcement, Carnival was able to borrow nearly $6 billion from large institutional investors...If the hardest-hit companies like Carnival, with its fleet of 104 ships docked indefinitely, could raise money in capital markets, who couldn’t?

Let's be clear who is bailed out here: Creditors. People who lent lots of money to shaky businesses, earned nice high yields in good times, now have the Fed and Treasury bail them out in bad times. 

It worked. 

Today, nearly two years later, most agree that the Fed’s actions helped to save the economy from going into a pandemic-induced tailspin.

I agree. A crisis was imminent, a toppling of a vastly over-leveraged house of cards was in the works. As "just in time" supply chains discovered they needed a bit of extra inventory around, just in time debt financing falls apart at the slightest shock, needing a bit of cash inventory and equity buffer. 

The Fed’s initial response in 2020 received mostly high marks—a notable contrast with the populist ire that greeted Wall Street bailouts following the 2008 financial crisis. North Carolina Rep. Patrick McHenry, the top Republican on the House Financial Services Committee, gave Mr. Powell an “A-plus for 2020,” he said. “On a one-to-10 scale? It was an 11. He gets the highest, highest marks, and deserves them. The Fed as an institution deserves them.”

I also agree, almost. But  

The question now is what will be the long-term costs and implications of that emergency activism—for the Fed, the financial markets and the wider economy. 

This is the question. Why did the economy get into a situation once again, so soon, that the Fed had to engineer this massive bailout? What are you going to do to make sure you don't have to do it again and again? 

Free to transact

What rights do we need to guarantee our political freedom. Well, the right to speak freely, of course. The right peaceably to assemble, and to petition the government for a redress of grievances. Even in trucks. 

But without economic freedom you cannot have political freedom. The right to work, which requires the right to hire. If the government, or political pressure groups, can stop you from being hired, you cannot speak, you cannot assemble, you cannot act politically. Communist countries didn't need to put people in jail. They could just stop them from working. 

And the right to transact, freely and anonymously. If the government can monitor your transactions, freeze your assets, "sanction" you, or freeze your ability to transact, to buy or sell anything, it can quickly silence you, stop your political participation, undermine political movements or even aspiring individual politicians. 

This is playing out in Canada right now. I have stated the principle before, but now we have a good example before us of just what the danger is. I don't care how you feel about the truckers, but look at the power the government has used to silence their political protest. The government can use the same power to silence individuals. Or protests from the left. 

Reports that there are bank runs and outages as Canadians try to quickly take money out of banks are an interesting consequence. 

This is going to be a hard question as we move to electronic transactions, whether fintech or crypto. If we have arbitrary, cheap, completely anonymous transactions, tax evasion, theft (ransomware), fraud, can go haywire. If we have complete surveillance and control, political  liberty goes out the window. 

Is the Fed really clairvoyant?

 Fed Pick Raskin Tries to Mollify GOP Critics on Climate Stance is the Bloomberg.com headline. 

I previously praised Raskin for the clarity of her statements. Unlike most others in this game, she straightforwardly advocated the Fed starve fossil fuel companies of money in the name of climate. For example  

“We must rebuild with an economy where the values of sustainability are explicitly embedded in market valuation,” she wrote. This will require “our financial regulatory bodies to do all they can—which turns out to be a lot—to bring about the adoption of practices and policies that will allocate capital and align portfolios toward sustainable investments that do not depend on carbon and fossil fuels.”

Good. Let's stop pretending there is some "climate risk" and talk honestly. 

As Bloomberg reports, she is furiously backpedaling 

“The Federal Reserve does not engage in credit allocation and does not choose the borrowers to whom banks extend credit,” she wrote.

But she did see some potential for the Fed to act, particularly in analyzing the climate risks facing supervised institutions. 

Those financial risks “might include disorderly price adjustments in various asset classes; potential disruptions in proper functioning of financial markets; and rapid changes in policy, technology, and consumer preferences that markets have not anticipated.”

This seems like more climate-risk boilerplate. 

But the last paragraph here caught my eye, and is the point of this blog post. Read it closely. This is supposed to reassure us? Forget climate. The future head banking regulator thinks the Fed actually has the capacity and mandate to try to foresee and do something about "disorderly price adjustments" in "various asset classes" -- that means all over the financial system including stocks -- "potential disruptions" and best of all  "rapid changes in policy, technology, and consumer preferences that markets have not anticipated"

Really? This is, remember, the same institution that was completely surprised by inflation, completely surprised by a pandemic (we've never had those before, have we?) and completely surprised that mortgages and mortgage backed securities might melt down. 

The gap between aspiring technocrats' view of their all-seeing knowledge, control,  and reality seems pretty large! If the stability of the financial system depends on Fed appointees clairvoyantly foreseeing "rapid changes in policy, technology, and consumer preferences" that banks don't even consider as risk-management possibilities... heaven help us. 

Meanwhile Green Stocks Stumble reports WSJ

Electric-vehicle startups and other green tech companies soared early last year. Now a wave of investigations, outside allegations and growing investor skepticism have sent shares down 75% or more for many of them.

If we were going to be honest about "asset classes" that might have "disorderly price adjustments" due to "rapid changes in policy" (subsidies end, midterm elections,) and consumer preferences, should we just maybe look at vastly over-priced, no revenue in sight, heavily subsidized, ESG labeled, regulator-approved green stocks, bonds, venture, and bank lending? Are we not even possibly heading towards another Fannie and Freddy, only this time subsidized green boondoggles? If "markets" aren't "valuing" green investments correctly, isn't it remotely possible that they are valuing them too much?

Update: 

I should have added: there is no such thing as an "orderly" price adjustment. If you know prices are going down tomorrow, you sell today. One of the most classic policy fallacies is the idea that we can have a slow steady price decline. 

Interest-rate surveys

 

Torsten Slok, chief economist at Apollo Global Management, passes along the above gorgeous graph. Fed forecasts of interest rates behave similarly. So does the "market forecast" embedded in the yield curve, which usually slopes upward. 

Torsten's conclusion: 

The forecasting track record of the economics profession when it comes to 10-year interest rates is not particularly impressive, see chart [above]. Since the Philadelphia Fed started their Survey of Professional Forecasters twenty years ago, the economists and strategists participating have been systematically wrong, predicting that long rates would move higher. Their latest release has the same prediction.

Well. Like the famous broken clock that is right twice a day, note the forecasts are "right" in times of higher rates. So don't necessarily run out and buy bonds today. 

Can it possibly be true that professional forecasters are simply behaviorally dumb, refuse to learn, and the institutions that hire them refuse to hire more rational ones? 

My favorite alternative (which, I admit, I've advanced a few times on this blog): When a survey asks people "what do you 'expect'?" people do not answer with the true-measure conditional mean. By giving an answer pretty close to the actual yield curve, these forecasters are reporting a number close to the risk-neutral conditional mean, i.e. not \(\sum_s\pi(s)x(s)\) but \(\sum_s u'[c(s)]\pi(s)x(s)\). The risk-neutral mean is a better sufficient statistic for decisions. Pay attention not only to how likely events are but how painful it is to lose money in those events. Don't be wrong on the day the firm loses a lot of money. The weather service also tends to overstate wind forecasts. I interpret the forecast of 30 mph winds as "if you go out and capsize your boat in a 30 mph gust, don't blame us." "If you buy bonds and they tank, don't blame us" surely has to be part of a finance industry "forecast." 

If the risk-neutral mean equals the market price, do nothing. And do nothing has to be the advice to the average investor. Reporting the forecast implied by the yield curve directly has a certain logic to it. 

Economists rush too quickly, I think, from surveys where people are asked "what do you expect?" to bemoaning that the answers do not represent true-measure conditional means, and blaming that on stupidity. As if anyone who answers the question has the vaguest idea what the definitions of mean, median, mode, conditional and true vs. risk-neutral measure are. We might have a bit more humility: They're giving us a sensible answer, to a question posed in English, but since we asked the question in a  foreign language, it is an answer to a different question. 

(Teaching is good for you. Most of my students did not understand that "risk" can mean you earn more money than you "expected," at the beginning of the class. I hope they got it by the end! But they were not wrong. In English, "risk" means downside risk. In portfolio analysis, it means variance. Know what words mean.) 

But that also means, do not interpret the answers as true-measure conditional means! 

This graph is particularly challenging since it concerns the 10 year rate only. Similar graphs of short-term rates also show consistent bias toward forecasting higher rates that don't happen. But that is more excusable as a risk-neutral mean, since the yield curve slopes up in the first few years. A rising forecast of 10 year yields corresponds to slope from 10 years to longer maturities, which is typically smaller. Torsten, if you're listening, a comparison to the forecast implied by the forward curve at each date would be really interesting! 

***

Update: The same students who used the English meaning of "risk" to be "downside risk" also used the English meaning of "expected" to be "what happens if nothing goes wrong," somewhere in the 90th percentile. The two meanings do make some sense, properly understood, especially in a world with skewed distributions -- the lion gets you or does not, the plan crashes or does not, the bomb explodes or does not. Many important distributions are not normal, so mean and variance aren't appropriate! 

I don't mean to say that surveys are useless. They are very important data, that can be very useful for forecasting events. If the survey forecast points up, that tells you something. A forecasting regression that includes survey data can be very useful. Just don't interpret it directly as conditional mean and blather about irrationality if it isn't. 

The variation across people in survey forecasts is the really interesting and under-studied part of all this. The graph is the average forecast across forecasters. But individual forecasters say wildly different things. Even these, who are professional forecasters. Why do survey forecasts vary across people so much, though the people have the same information? Why do trading positions not vary over time or across people anything like the difference between survey forecasts and market prices says they should? I think we're missing the interesting part of surveys -- their heterogeneity, with little heterogeneity of actions. 

 

Stock market fall and long-term investors

 

Having just plugged "portfolios for long-term investors" again, I really should opine on its message about the recent stock market decline. If you didn't see this coming and get out ahead of time, or if it was perfectly obvious to you that this was coming but you didn't get off your butt and do anything about it, preferring to pontificate at the dinner table, just how bad should you feel about it? 

Not as bad as you might think. 

Portfolios for long-term investors

"Portfolios for long-term investors" is published, Review of Finance 26(1), 1-42. (2022). This standard link works if you have institutional or individual access. I am not allowed to post a free access link here, but I am allowed to post one on my webpage where you will find it. 

The theme: How do we account for the vast gulf between portfolio practice and portfolio theory? How do we make portfolio theory useful given that the world has time-varying expected returns and time-varying returns and correlations? I argue for a view more focuses on prices and payouts, as a long-term bond investor should buy an indexed perpetuity and ignore one-period returns. I advise one to think about the market and equilibrium. The average investor must hold the market portfolio. Anything else is a zero sum game. So figure out why you are different than average. (If you think you're smarter than average, note that they think they're smarter than you.) The result encapsulates some ancient advice: Buy stocks for the dividends, broadly interpreted. Take risk you are well-positioned to take. If stocks have great value to other investors for reasons either technical (liquidity, short-sales constraints, etc.) or behavioral, avoid them. 

The paper grows out of the summary I used to give for MBA and PhD students. There aren't any equations, but there are lots of suggestions about how academic portfolio theory might be done better, and connect better to its intended audience. Thanks especially to Monika Piazzesi and Luis Viceira, who invited me to give the talk on which it is based, and Alex Edmans who shepherded it to publication. 

******

Update: I just found that the NBER has posted the original lecture video

Fed Nominees

I salute President Biden's nominations for the Federal Reserve Board, especially Sarah Bloom Raskin and Lisa Cook. (Philip Jefferson seems straightforward and uncontroversial, but other than reading a CV I haven't looked that hard.)

 We can now have an honest conversation about where the Fed is going, and whether and how the Fed should use its tools, primarily regulation, to advance the Administration's agenda on climate, race, and inequality. 

The Wall Street Journal nicely assembled crucial quotes on Ms. Raskin and climate. In 2020,   

The Fed established broad-based lending programs to prevent businesses that were otherwise sound from failing due to the shutdowns. 

Writing in the New York Times in May 2020, 

Ms. Raskin wanted the Fed to exclude fossil-fuel companies from these facilities. “The Fed is ignoring clear warning signs about the economic repercussions of the impending climate crisis by taking action that will lead to increases in greenhouse gas emissions at a time when even in the short term, fossil fuels are a terrible investment,” she wrote. ...

“The Fed’s unique independence affords it a powerful role,” Ms. Raskin added. “The decisions the Fed makes on our behalf should build toward a stronger economy with more jobs in innovative industries—not prop up and enrich dying ones.”